Statement on Complex Exchange-Traded Products
Oct. 4, 2021
Last Friday the Commission voted to approve a pair of proposed rule changes by Cboe BZX Exchange, Inc. to list and trade shares of new exchange-traded products: the 2x Long VIX Futures ETF and the -1x Short VIX Futures ETF.[1] While we supported the approval of these rule changes, we want to emphasize the importance of taking steps to update the regulatory framework for these and other similar products.
In recent years, our markets have seen a proliferation of novel and complex exchange-traded products.[2] These products may be useful to certain investors who understand their unique features. However, they can also pose significant investor protection issues and, in periods of market stress or volatility, may contribute to broader systemic risks.[3] We believe it is time for the Commission to update the rules for these products. Below, we outline three key principles that should apply to an updated regulatory framework.
- Ensure strong, consistent regulatory oversight of all complex exchange-traded products
The Commission should endeavor to adopt a consistent approach to exchange-traded products with similar features (and in many cases, similar names). Some exchange-traded products are registered investment companies and are therefore subject to the requirements of the Investment Company Act designed to protect investors, such as limitations on a fund’s ability to incur leverage,[4] requirements for boards of directors and chief compliance officers, and prohibitions on affiliated transactions.[5]
However, products that are registered exclusively under the Securities Act of 1933 are not subject to the same requirements that apply to products that are registered under the Investment Company Act of 1940, even if those products pursue similar objectives and present many of the same types of risks. These other products include, for example, exchange-traded notes, commodity pools, and structured notes, many of which refer to themselves as “funds” even though they are not, in fact, registered investment companies. While there are differences in the structures of these products, they can pose similar risks to investors and the markets, and the Commission should endeavor to adopt a consistent approach to managing such risks to ensure that our rules do not needlessly create opportunities for regulatory arbitrage.
- Take a consistent, holistic approach to the review of exchange-traded products
Second, the Commission should take a holistic approach to the listing processes for exchange-traded products that considers the potential for such products to cause or contribute to risk in the financial system. Exchange-traded products pursuing a popular strategy or with a positive track record may be likely to grow in both size and number, thereby magnifying any potential impact that such products may have on the broader financial system.[6] As commenters have noted, it is important that our review take into account a market-wide view of the possible risks of these products.[7]
- Provide heightened protections with regard to investors’ trading of complex exchange traded products
Third, and perhaps most critically, the Commission should adopt and implement a tailored sales practices framework that applies to the recommendation and trading of complex exchange-traded products commensurate with the risks these products present. Many exchange-traded products have features that may make it difficult for investors—and even financial professionals—to understand their characteristics and risks. For example, leveraged and inverse exchange-traded products are typically designed to achieve stated performance objectives on a daily basis. They “reset” every day with respect to their relationship to an underlying index. This can cause returns to vary substantially from the performance of the underlying index, especially if they are held over a longer period of time. These effects are especially pronounced in volatile markets.[8]
The Commission previously considered, but ultimately failed to adopt, tailored sales practices requirements for leveraged and inverse investment companies that would have added important protections for investors in self-directed accounts.[9] We should renew that effort, and consider expanding it beyond registered investment companies to reach other types of complex exchange-traded products.
We are overdue for a comprehensive and consistent approach to the review of complex exchange-traded products and the sales practices issues that they present. We look forward to working with our colleagues to address the investor protection concerns and potential systemic risks that certain exchange-traded products can entail.[10]
[1] Order Setting Aside Action by Delegated Authority and Approving a Proposed Rule Change, as Modified by Amendment Nos. 2 and 4, to List and Trade Shares of the 2x Long VIX Futures ETF Under BZX Rule 14.11(f)(4) (Trust Issued Receipts), Release No. 34-93299 (October 1, 2021) (the “Long Order”); Order Setting Aside Action by Delegated Authority and Approving a Proposed Rule Change, as Modified by Amendment Nos. 1 and 3, to List and Trade Shares of the -1x Short VIX Futures ETF Under BZX Rule 14.11(f)(4) (Trust Issued Receipts), Release No. 34-93230 (October 1, 2021) (the “Short Order”). By approving these rule changes, we want to be clear that the Commission is not expressing a view as to these products’ suitability, either as a general matter or with respect to any specific investor. See Long Order at 18 n. 64; Short Order at 19 n. 71. As commenters noted, leveraged and inverse exchange-traded products, in particular those linked to volatility, are complex and risky, and typically underperform their benchmarks over time. See Long Order at 17; Short Order at 19. As the Commission stated at the time of Regulation Best Interest’s adoption, leveraged and inverse exchange-traded products are “highly complex financial instruments” and the fact that they reset daily means such products are unlikely to be “suitable for, and as a consequence also not in the best interest of, retail customers who plan to hold them for longer than one trading session, particularly in volatile markets.” Regulation Best Interest: The Broker-Dealer Standard of Conduct, Release No. 34-86031 (June 5, 2019) at 263-264. The Commission explained further that these products are unlikely to be in the best interest of a retail investor absent an identified, short-term, customer-specific trading objective. Id. at 264.
[2] See, e.g., Ben Johnson, The Best and Worst New ETFs of 2020, Morningstar (December 22, 2020) (noting that a record number of new ETFs launched in 2020, including novel themed products); Michael Wursthorn, “Investors Pile Into Risky ETFs During Wild Market Rally - WSJ,” Wall Street Journal (November 29, 2020) (noting that leveraged and inverse exchange-traded products reached record levels of inflows in 2020).
[3] See Americans for Financial Reform Education Fund, Comment Letter on Notice of Filing of a Proposed Rule Change, as Modified by Amendment No. 1, to List and Trade Shares of the 2x Long VIX Futures ETF, a Series of VS Trust, under Rule 14.11(f)(4) ("Trust Issued Receipts") at 1 (May 7, 2021) (stating “[CBOE’s Volatility Index]-tied investments are a part of exotic and frequently speculative hedging strategies that could cause significant harm to investors”); Better Markets, Inc., Comment Letter on Notice of Filing of a Proposed Rule Change, as Modified by Amendment No. 1, to List and Trade Shares of the 2x Long VIX Futures ETF, a Series of VS Trust, under Rule 14.11(f)(4) ("Trust Issued Receipts") at 3 (May 7, 2021) (stating that “[f]ew [investors] understood the complex rebalancing provisions of products [such as a one inverted volatility index exchange-traded product], and the unique risks it posed.”); Healthy Markets Association, Comment Letter on Notice of Filing of a Proposed Rule Change, as Modified by Amendment No. 1, to List and Trade Shares of the 2x Long VIX Futures ETF, a Series of VS Trust, under Rule 14.11(f)(4) ("Trust Issued Receipts") at 3-4 (May 7, 2021) (noting concerns among some academics about new volatility-linked investment products and systemic risks). See also Jay Clayton, Dalia Blass, William Hinman, Brett Redfearn, Joint Statement Regarding Complex Financial Products and Retail Investors (October 28, 2020) (“[L]everaged/inverse products and other complex products may present investor protection issues—particularly for retail investors who may not fully appreciate the particular characteristics or risks of such investments, including the risks that holding such products may pose to their investment goals.”)
[4] The current limitations on registered funds’ ability to take on leverage are, in our view, insufficient. See Caroline Crenshaw, Commissioner, Sec. & Exch. Comm’n, Statement on Funds' Use of Derivatives (Oct. 28, 2020); Allison Lee, Commissioner, Sec. & Exch. Comm’n, Statement on the Final Rule on Funds' Use of Derivatives (Oct. 28, 2020). However, there is no such limitation for exchange-traded products that are not registered as funds.
[5] Sec. & Exch. Comm’n Rule, 17 C.F.R. § 270.18f-4 (2021).
[6] We note that the Commission’s finding that these rule changes are consistent with the Exchange Act is based on how the proposed rule operates under the current market conditions discussed in the order. See Long Order at 12 n.43; Short Order at 13 n.48. The Commission recognizes that, over time, the conditions in VIX ETP markets, and the related VIX futures market, may change. Id.
[7] Additionally, under our current regulatory framework, similar products undergo different listing processes based on how they are registered under the securities laws. For example, many complex products, such as those that the Commission approved in this order, do not qualify for listing under exchanges’ generic listing rules. Rather, depending on the product, the listing exchange may be required to adopt a specific listing rule for the relevant product, a process that gives the Commission and the public an opportunity to evaluate, among other things, the product and its likely impact on investors and the markets. In contrast, products qualifying as “exchange-traded funds” under Commission rule 6c-11 automatically qualify for listing under exchanges’ generic listing rules—without a corresponding opportunity for public notice and comment—despite the fact that leveraged and inverse products qualifying under that rule may present many of the same risks to investors and the markets. In our view, novel, complex exchange-traded products should undergo a robust review process before being listed on an exchange. In addition to the process by which products are listed, the Commission should review the process by which products are delisted. Some products may be delisted by their issuers in times of extreme volatility, pushing those products to the over-the-counter markets and thereby making it difficult for retail and other investors to recover funds. See Lizzy Gurdus, Exchange-Traded Note Delistings ‘Should be Criminal,’ Market Analyst Says, CNBC (Aug. 22, 2020). Accordingly, we should closely examine and address any deficiencies in the delisting process that can result in investor harm.
[8] See Americans for Financial Reform Education Fund, Comment Letter on Notice of Filing of a Proposed Rule Change, as Modified by Amendment No. 1, to List and Trade Shares of the 2x Long VIX Futures ETF, a Series of VS Trust, under Rule 14.11(f)(4) ("Trust Issued Receipts") at 2 (May 7, 2021) (“The magnification of losses and gains lead to markedly different returns than the long-term performance of the underlying indexes, and in general they significantly underperform these indexes. For example, in a 3x leveraged long ETF of the S&P 500, a 1% daily gain in the S&P 500 on a $100 balance would lead to a 3% ($3) return for the ETF holder. If however on the next day the S&P 500 drops by 2%, the ETF would lose 6%, or -$6.18 bringing the portfolio’s value to $96.82. On the third day, even if the S&P 500 were to regain the prior day’s losses and gain 2%, a 6% gain on that lower value would lead to a portfolio value of $102.6, below the $103 prior to the second day selloff.”)
[9] Crenshaw, supra note 4; Lee, supra note 4.
[10] Gary Gensler, Chair, Sec. & Exch. Comm’n, Statement on Complex Exchange-Traded Products (October 4, 2021).